Impact of Financial Leverage on Firm s Investment in Listed Hotels and Travels Companies in Sri Lanka

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1 Vol. 4, No. 4, 2015, Impact of Financial Leverage on Firm s Investment in Listed Hotels and Travels Companies in Sri Lanka M. Tharshiga 1, T. Velnamby 2 Abstract Leverage is a technique magnifies gain and loss. High leverage may be beneficial in boom periods; it may cause serious cash flow problems in recessionary periods. So this research study examines the impact of financial leverage on firm s investment using information on ten Hostels and travel companies listed on Colombo stock Exchange over the period of Random sampling is used for data collection. Analyzed results revealed that gross investment had significant impact on debt to equity at 0.01 significant levels. But fixed investment had not significant impact on debt to equity. Further it implies There is positive significant relationship between gross investment and debt to equity.r value indicates the.552 level of Strength at the 0.01 significant level and there is negative relationship between fixed investment and debt to equity But there is no significant relationship exist (p>0.05). Keywords: Financial leverage, Gross Investment and Fixed investment 1. Introduction Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company's perspective, the use of financial leverage can positively or sometimes negatively affect its return as a consequence of the increased level of risk. The most obvious risk of leverage is that it multiplies losses. Due to financial leverage's effect on solvency, a company that borrows too much money might face bankruptcy during a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause. When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments. Financing capacity will decrease with leverage ratio increasing. Without enough capital, the companies will select to invest projects with stable cash flow each year even if these choices are not the best ones. That is, insufficient fund will lead to under-investment (Raza et al., 2011). By doing research on agency cost and other externalities generated by debt financing, Myers (1977) derived that there is a significant positive correlation between debt ratio and under-investment. He pointed out that the interest conflicts between shareholders and creditors force enterprises to adopt a sub-optimal 1 Department of Financial Management Faculty of Management Studies & Commerce University of Jaffna 2 Dean Faculty of Management Studies & Commerce University of Jaffna 2015 Research Academy of Social Sciences 228

2 investment strategy, and then reduced the current market value of these enterprises. To an enterprise with debt financing, managers and shareholders tend to refuse the positive NPV projects whose major returns belong to the creditors. Green (1984) got the same conclusion as above: financing decisions are not separated from investment arrangements, and leverage may lead to wrong investment incentives. Clearly, the debt financing reduces the motivation on managers and shareholders, and weakens their initiative to invest valuable projects. Hence, firms with low leverage ratio have higher possibility to exploit opportunities as they emerge. One of the main issues in Corporate Finance is whether financial leverage has any effects on investment. The corporate world is characterized by various market imperfections, due to transaction costs, institutional restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems and that may result in under-investment or over-investment incentives. Whenever we refer to investment, it is essential to distinguish between overinvestment and under-investment. Thus, leverage is one mechanism for overcoming the overinvestment problem suggesting a negative relationship between debt and investment for firms with weak growth opportunities. Too much debt also is not considered to be good as it may lead to financial distress and agency problems. Cantor (1990) explained that highly leveraged firms show a heightened sensitivity to fluctuations in cash flow and earnings since they face substantial debt service obligations, have limited ability to borrow additional funds and may feel extra pressure to maintain a positive cash flow cushion. Hence, the net effect would be reduced levels of investment for the firm in question. Statement of Problem Investment of a company is the financing by primarily, owners funding and funding from lenders. The choice of the combination of this funding is made by the managers of the businesses and they decide whether to borrow, plough back the profits the business has made, or to ask the owners to raise more funds to expand the business, or to increase the shareholders payout of returns on their investment. The combination of the sources of business funding is referred to, as the capital structure of that business. An investor who would like to be rational and scientific in his investment activity has to evaluate a lot of information about past performance and the expected future performance of the companies, industries and the economy as a whole before taking the investment decision and hence, the this study will attempt to analyze the impact of financial leverage on return on investment of selected listed companies in Sri Lanka. Significant of this Study Significant of the study should answer three questions. They are will this study generate new knowledge? Will the study benefit stakeholders, advance understanding or influencing policy? And will the study fill the gap in existing knowledge? This present study gives positive answer for three questions. The significant of the study is to enable us to evaluate how impact of the financial leverage on firm s investment. Especially we have the critical look on changes in fixed investment and gross investment due to financial leverage Changed. This study will therefore enhance an understanding on how financial leverage can be said to thrive well in an economy that is forming in that as dept employed more founds to increase, for investment and as such profit fends to increase. Managers of the companies can understand how financial leverage impact on capital employed. Because normally financial leverage magnifying the shareholders wealth. So changes in the financial leverage lead to change the shareholders wealth. Stakeholders can understand how much money committed in the business as investment. Objective of the Study The research question serves as the basis of the study. Following are the objective of the study: 229

3 M. Tharshiga & T. Velnamby To evaluate what extent financial leverage influence on investment of Sri Lankan listed companies To examine the relationship between financial leverage and investment in selected companies 2. Literature Review Many authors have studied leverage and its determinants and conducted their study in different countries using different techniques. This has led to different outcomes and results. Myers (2001) stated there are many theories that explain the concept of leverage. There exists no universalistic theory about leverage because the explanatory power of theories that might explain leverage is based on various conditions and circumstances. Anandasayanan,S& Subramaniam,V.A(2013) examined Effect of Capital Structure on profitability of Listed Manufacturing Companies in Sri Lanka. Their sample consists of 12 Manufacturing companies listed in Colombo stock Exchange and their results revealed that significantly negative relation between debt and profitability. The successful selection and use of capital is one of the key elements of the firms financial strategy (Kajananthan, 2012).Velnampy &. Aloy Niresh.J made an attempt to find out the Relationship between Capital Structure and profitability of ten listed Sri Lankan banks over the past 8 year period from 2002 to They found that there was a negative relationship between capital structure and profitability. Further the results suggest that 89% of total assets in the banking sector of Sri Lanka are represented by debt, confirming the fact that banks are highly geared institutions. Anansasayanan (2013) analyzed The determinant of leverage of the listed companies in Sri Lanka: An empirical Study. The purpose of present study was to investigate the determinants of leverage decision of Sri Lankan firms based on a panel data set over a period of five years from comprising of 60 companies. This study examined the impact of five firm specific factors firm size, firm growth rate, profitability, and asset tangibility, on the leverage decision of listed companies in Sri Lanka. The results showed that financial leverage of Sri Lankan firms is influenced by firm size, firm growth rate and profitability.this study contributed to the literature on the factors that influence financial leverage of the firm. Xin & Lin (2006) noticed that investment is sensitive with debt level for those non-state-owned listed companies. With an increase in proportion of state-owned shares, the sensitivity will fall down. Bertrand, Schoar and Thesmar (2007) noticed that banks are reluctant to offer a loan to those firms which have low growth opportunities. At the same time, other firms which can get external capital from banks are more willing to invest. Jothi, K. (2010) in his study had analyzed the significant level of financial risk on capital structure of fifty nine companies-ten each from cement, Food, Pharmaceutical, Steel, Textile and nine from Information Technology from to He found that proportion of debt fund provided by long-term as well as by shortterm debt is significantly related to level of financial risk of firms under these industries. Lang (1996) was one of the first authors to empirically examine the relationship between leverage and investment controlling for growth opportunities at the firm level. Using a basic investment regression model and a US sample, the author found that leverage reduces investment and concluded that the negative relationship was due to agency problems. The negative relationship between leverage and investment is stronger for firms with low growth opportunities. Growth opportunities were measured using Tobin s Q which measured the difference between market value and book value of assets. The found results hold for different industries. The author concluded that the negative relationship between investment and leverage applied to firms with high growth opportunities, but only to those firms with growth opportunities that were not recognized by the external market. The author however did not mention that the found negative relationship between leverage and investment does not necessarily mean that overinvestment or underinvestment is present. Furthermore, it is not clear which agency problem is more persistent. 230

4 Aivazian et al. (2005) indicated that tangible assets increase the use of the leverage by reducing the bankruptcy cost, and find that the correlation between tangible assets and investment opportunities is not high. At the first stage, the firm s leverage decision function consists of the ratio of tangible assets to total assets, as instrumental variables, and those in the investment function as control variables. They conducted an F-test to test the hypothesis that the instruments cannot explain firm leverage, and we reject this hypothesis at the 1% level. 3. Conceptualization Following are the research conceptualization Gross Investment Financial Leverage Firm s Investment Figure 1: Developed by Researchers Fixed Investment Table 2: Operationalization Concept Variables Indicators Measurement Leverage Financial leverage relationship Between Debt/equity Debt and equity Investment Gross Investment PAT+ depreciation Dividend +Δ equity +Δ debt+ Advertisement expenses + R& D expenses Fixed investment Cash outflows for acquired fixed assets/ Total fixed assets Key Variable Definition Financial Leverage It indicates what proportion of equity and debt the company is using to finance its assets Debt to Equity = Total liabilities Gross Investment Share holders Fund Gross investment represents the total investment of the firm and be mathematically represented as follows: Gross investment = profit after tax + depreciation Dividend + changes in equity + changes in debt + advertisement expenses + research and development expenses Fixed Investment Fixed investment represents fixed assets acquired by company out of total assets Fixed investment = Cash outflows for acquired fixed assets Total fixed assets 231

5 Research Hypotheses M. Tharshiga & T. Velnamby Following Hypothesis are developed for this study H1: There is a significantly impact of Financial leverage on Investment H1a: There is a significantly impact of Financial leverage on gross Investment H1b: There is a significantly impact of Financial leverage on fixed Investment H2: Financial Leverage significantly correlated with investment H2a: Financial leverage significantly correlated with gross investment H2b: Financial leverage significantly correlated with fixed investment Sampling The study will adopt an analytical and descriptive research design. The data of the sample companies will be collected from the annual reports and the balance sheet published by the companies and the websites of the companies. Ten listed companies are selected from hotels and travel companies for this study on basis of sacrificed random sampling method. Data collection Data are collected from selected Companies financial statement through Colombo stock exchange web site over the period of Data Analysis and Discussion Correlation Analysis Table 2. Correlations Debt to equity gross investment Pearson Correlation.552 ** Sig. (2-tailed).000 fixed investment Pearson Correlation Sig. (2-tailed).130 **. Correlation is significant at the 0.01 level (2-tailed). Above table 2 explores that relationship between financial leverage and investment. from the analyzed results revealed that there is positive significant relationship between gross investment and debt to equity (p<0.01). r value indicates the.552 level of Strength at the 0.01 significant level. Further this table explains that there is negative relationship between fixed investment and debt to equity. But there is no significant relationship exist.(p>0.05) Model Table 3.ANOVA b Sum of Squares df Mean Square F Sig. 1 Regression 3.850E E a Residual 8.803E E15 Total 1.265E17 49 a. Predictors: (Constant), Debt to equity b. Dependent Variable: Gross investment 232

6 Based on the analyzed results we can accept hypothesis (H2b) because there is significant relationship between gross investment and debt to equity (r=0.552) and (p<0.01). but there is no significant relationship between fixed investment and debt to equity (p>0.05). Therefore hypothesis ( H2b) is rejected In the table 3 focused on F statistic. The information to pay attention to here is the probability shown as Sig. in the table. From this analysis results revealed that the F-statistic is large enough to accept the hypothesis Table 4 explains that impact of debt to equity on gross investment. This result explained 30.2% of variance explained by debt to equity. The first important thing to note is that the sign of the coefficient of debt to equity (%) is positive. Further implies that the slope is not statistically significant. But debt to equity is statistically significant at 0.01 levels. Regression model is gross investment = E E6 debt to equity +ε Therefore hypothesis (H1a) is accepted Table 5 Coefficients a Model Model Unstandardized Coefficients Table 4.Coefficients a Unstandardized Coefficients Standardized Coefficients B Std. Error Beta Standardized Coefficients B Std. Error Beta 1 (Constant) E E (Constant) De t Sig. R Square a. Dependent Variable: Fixed investment Above table 5 exhibits that influence of fixed investment on Financial leverage. From the analyzed results the slop (α) is statically significant (p<0.01) but debt to equity is not significant impact on fixed investment (p>0.05) further it has least impact on dependent variable( r =4.7). regression model is as follows fixed investment = debt to equity +ε t Sig. debttoequity 5.379E E R Square.304 a. Dependent Variable: gross investment Table 6. ANOVA b Model Sum of Squares df Mean Square F Sig. 1 Regression a Residual Total a. Predictors: (Constant), Debt to equity b. Dependent Variable: Fixed investment 233

7 M. Tharshiga & T. Velnamby Table 5 shown above ANOVA results. F is laid down in the acceptance region. F-statistic is not enough to accept the hypothesis Therefore hypothesis (H1B) is rejected 5. Conclusion This research is an attempt to analysis the impact of financial leverage on investment. For this study purpose data can be drawn from ten hotel and travel companies listed in Colombo Stock Exchange in Pearson correlation and regression are used to analysis the data. From the regression analyzed results expressed that gross investment had significant impact on debt to equity at 0.01 significant levels. But fixed investment had not significant impact on debt to equity. From the correlation analyzed results revealed that there is positive significant relationship between gross investment and debt to equity (p<0.01). r value indicates the.552 level of Strength at the 0.01 significant level. Further this study explains that there is negative relationship between fixed investment and debt to equity. But there is no significant relationship exist (p>0.05). Reference Anandasayanan(2013) The determinant of leverage of the listed companies in Sri Lanka; An empirical Study.International Journal of Research in Commerce & Management Volume 03, Issue No06June. Anandasayanan & Subramaniam(2011) Effect of Capital Structure on profitability of Listed Manufacturing Companies in Sri Lanka ; Eighth international conference on business management Aivazian, V.A., Ge, Y., Qiu, J.P., The impact of leverage on firm investment: Canadian evidence. Journal of Corporate Finance 11, Bertrand, M., Schoar, A., and D. Thesmar (2007), Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985, Journal of Finance, 62, Myers, S., Determinants of corporate borrowing. Journal of Financial Economics 5, Myers and Turnbull (1977), Capital Budgeting and the Capital Asset Pricing Model: Good News and Bad News. Journal of Finance 32, pp Modigliani, F. & Miller, M., (1958), The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), pp Raza, S. A., Ali, S. A., & Abassi, Z. (2011). Effect of corporate income tax and firms size on investment: evidence by Karachi stock exchange. MPRA Paper No , University Library of Munich, Germany. Velnampy(2012) Relationship between Capital Structure and profitability of ten listed Sri Lankan, Global Journal of Management and Business Research,Volume 12issue 13 version. 234